Wednesday, July 31, 2013

Before Investing in Another Hedge Fund, There’s Required Reading

Before Investing in Another Hedge Fund, There’s Required Reading

Before anyone makes an investment in a hedge fund, they should be required to read one book: Barbara Dreyfuss’ Hedge Hogs: The Cowboy Traders Behind Wall Street's Largest Hedge Fund Disaster.  Whether you serve on an investment committee, a retirement board, or act as a sole fiduciary,        you should not make another investment in hedge funds until you’re done with this book.  Better yet, you ought to have your entire staff read it as well, and then schedule a meeting to discuss it.   While you are getting folks to read the book, add your consultant, actuary, and custodial bank to the list of required readers.

Ms. Dreyfuss chronicles the demise of Amaranth Advisers, a multi-strategy hedge fund that allowed its natural gas trader to build a series of investment positions that wiped out a majority of its investors’ capital.  The book contains some dramatic scenes, especially when Brian Hunter, Amaranth’s star energy trader, desperately tries to trade out of his untenable position.   However, the real value of this book comes in the details, and that is why Hedge Hogs is so important.  Ms. Dreyfuss shows how Mr. Hunter slowly amassed the means to destroy Amaranth, despite all the risk managers and risk management systems deployed by the firm.

Gatwick (2006)

There are times when you have to read this book slowly in order to grasp how Mr. Hunter and his competitors at other hedge funds are placing their bets on natural gas prices.  However, it is important to understand what is going on, because this small group of traders made speculative bets that were much bigger than the physical market for natural gas.  In other words, we get to see what happens when too much institutional capital swamps just one tiny niche of the investment marketplace.  We also find out that these speculative excesses have consequences for the real economy.  Ms. Dreyfuss details how Mr. Hunter’s trades distorted the natural gas market and made it nearly impossible for utilities, manufacturers, and other businesses to hedge their energy costs.

I am not recommending this book because it will help investors avoid making mistakes.  Rather, they need to read this book to help them prepare for dealing with the inevitable problems that will befall their hedge fund investments.  As more and more money flows into these types of speculative investments, there will be more implosions.  What happened to Amaranth isn’t the by-product of some cataclysmic event like the credit bubble.  Instead, Ms. Dreyfus reveals that an ordinary, well-diversified investment can turn toxic, when too much money meets someone who is willing to gamble with it.  For all of those investors who think that their investment checklists, scrupulous due diligence, and risk models will steer them clear of the next Amaranth, read the book and think again.  There’s probably another Amaranth already in your portfolio; you just don’t know it.


Tuesday, July 30, 2013

Time to End the Reign of the Quartet: Yellen for Fed Chairman

Time to End the Reign of the Quartet: Yellen for Fed Chairman

I guess the case against Lawrence Summers to be Fed Chairman is pretty obvious.    Today’s lead editorial in The New York Times endorses Janet Yellen to be the next Fed Chairman and uses many of the same arguments I have against elevating Mr. Summers to the position.[1]  If I hadn’t drafted the post a few days I might have just recommended that you read today’s Times editorial.

Some time during the tenure of the next Chairman, we are likely to have another financial crisis.  Although our banking system has replenished its capital, thanks to taxpayers and the Fed, the big players in the industry are more concentrated than ever.  The new regulatory framework being constructed out of the Dodd-Frank legislation is replete with exceptions and loopholes.  At some point, the next Fed Chairman is going to confront some kind of crisis brought on by our failure to institute true reform.
On Line Trading (1999)
Lawrence Summers comes from a long line of Democrats who planted the seeds of the credit bubble in the 1990s and then made sure that Wall Street and the banks were spared from fundamental change when the financial crisis hit.  Mr. Summers is a member of a quartet of Democratic policymakers that includes Robert Rubin, Timothy Geithner, and Gene Sperling.  After pushing financial deregulation in the Clinton Administration as Treasury Secretary, Mr. Rubin headed to Citicorp where he helped drive the bank to the brink of failure.  Mr. Geithner learned his craft from Robert Rubin, went on to be President of the New York Fed as the bubble inflated, and presided over TARP, which saved Citicorp.  Mr. Sperling is Executive Director of the National Economic Council, Mr. Summers’ position before he left the Obama Administration.  Mr. Sperling, along with Mr. Summers, was the principal negotiator for the Clinton Administration of financial deregulation, known as Gramm-Leach-Bliley.

Mr. Summers is the fourth member of the quartet.   In my mind, one of the best reasons for opposing his candidacy for Fed Chairman occurred back in 1998, when Brooksley Borne, President Clinton’s chairwoman of the Commodities Futures Trading Commission, proposed the regulation of the over-the-counter derivatives market.  Messrs.’ Rubin and Summers were joined by Fed Chairman Alan Greenspan and SEC Chairman Arthur Levitt in eviscerating her proposal.  We’d have been spared a great deal of financial pain if Ms. Borne’s proposal had been implemented.  Instead, the quartet helped to push through legislation making it impossible for the CFTC to regulate a large portion of the derivatives market. 

While Messrs.’ Greenspan and Levitt have expressed some regret over their role in turning Wall Street into a casino, Mr. Summers has largely stuck to his position.  Given his shoddy treatment of Ms. Borne, it’s not surprising that he treated former FDIC Chairman Sheila Bair with disdain as she tried to reign in the banks in the aftermath of the financial crisis.  We know what we’ll get with Mr. Summers, and I think we’ve had enough of it.

We’ve had twenty years of the policies and conduct orchestrated by the Rubin, Summers, Geithner, Sperling quartet.  It is time to put this era completely in our past.


Monday, July 29, 2013

The Speculation State: North Carolina Gambles With Its Budget and Pension

The Speculation State: North Carolina Gambles With Its Budget and Pension

What a great time to be a wealthy person in North Carolina.  Governor Pat McCrory and the General Assembly have given you a tax cut you didn’t need, while creating an investment environment in North Carolina that will encourage you to invest any place other than your home state.  The budget enacted by the legislature will create an economic and social climate in North Carolina that is antithetical to sound long-term investment.  Why would anyone make a long-term investment in North Carolina when the legislature isn’t willing to invest in our schools and colleges?  Why should they consider sinking money into North Carolina when our state and local governments will lack the funds to provide basic services?  North Carolina developed a reputation as a progressive state under the leadership of Democrats and Republicans over a forty-year period.   In one session of our legislature much of the good work has been undone. [1]
Remediation (2006)
The damage done by our elected officials is so great that it will even penetrate the walls of gated communities in the hills above Asheville, on the outskirts of Chapel Hill, and behind the dunes on the outer banks.  Thus, the good times will not last for even the wealthy in North Carolina.  Our legislature and governor have created an economic and social climate that will eat at any one with a conscience.

However, it’s always a great time to be big-time money managers.   The General Assembly and our State Treasurer have news that will get them to interrupt their vacations on the Hamptons, clamber onto their G650s, and fly on down to Raleigh.  Senate Bill 558 passed both houses of the General Assembly, and when the Governor signs the bill, private equity and hedge fund managers will have even more opportunities to pad their pocketbooks.  The legislation allows the state’s public pension plans to increase their investments in alternatives.  It’s hard to say exactly how much this legislation is worth to money managers, because the State Treasurer doesn’t disclose how much of the pension is invested in hedge funds.  A chunk of these investments are buried in a broad category called Global Equity.  I’m guessing that money managers will make an additional $75 to $100 million in management fees annually when the increased allocations to alternatives are completed.[2]  Wall Street traders and investment bankers will probably earn a similar amount in commissions, fees, and expenses from the underlying investment funds.  And by the way, this isn’t a one-time deal.  They’ll earn this kind of money year in and year out.

The goal of this further foray into alternatives is to earn a higher return for the pension plan in order to prevent the plan from running a larger long-term deficit.[3]  By now you probably know that I am skeptical of this approach, because I don’t think large institutions can earn decent long-term returns from most alternative strategies.  It is simply too much money chasing too few profitable ideas.

The push into alternatives also has a bad side effect that is entirely consistent with the policies espoused by our state legislature.   Many of the alternatives entering the pension plan, aren’t investments at all; they are short-term speculations.[4]  While the pension plan has long-term obligations to its beneficiaries, more and more of its assets are being plowed into options, futures, swaps, and other short-term trading strategies.   While there’s some small risk that these speculative endeavors could unwind, I am more concerned about the profound mismatch between short-term bets and long-term liabilities. 

Apparently, long-term investing in North Carolina, whether it’s in our schools, roads, or pension plans is a thing of the past.  We have become the speculation state.  Our legislature having departed the scene, the tally is clear.  Hundreds of millions of dollars were available for the wealthy and money managers, but no money was available for the poor, our teachers, or state employees.  For those of us with money to invest, the message is rather obvious.  Look elsewhere.

[1] See, for an excellent summary of the General Assembly’s damaging handiwork.

[2] A small group of managers will earn large bonuses or carry.  This bounty will amount to another $100 to $200 million, but you’ll never know about it, because pension plans don’t reveal this information.  At least, those investments will have earned something of a decent return.

[3] The pension plan must earn more than 7.25% over the long run, or the accounting rules require the legislature to increase the state’s financial support for the pension.  If the return assumption were reduced to a more realistic level of 6.75% or 7%, it would also trigger increased contributions.  Since our General Assembly is fiscally irresponsible to begin with, it’s doubtful that they’d increase the appropriation for the pension.  Thus the Treasurer has to hope hedge funds, private equity, commodities, and real estate can fill the gap.

[4] Alternative investments should be classified into two categories: investments, which include private equity, real estate, and perhaps certain credit strategies; and, speculations, which encompass many hedge funds and commodity strategies.  The problem with the investment category is that too much institutional capital is chasing the same strategies, so it will be very challenging to generate the expected returns.  In other words, almost everyone is making the same bet on what would otherwise be legitimate investments.    The speculative category is also attracting too much money, but it is also no place in a pension plan.  Of course, both categories are infused with ridiculously high fees.

Saturday, July 27, 2013

My second column in the Raleigh News & Observer

The Key Question in Selecting A Money Manager

Must Read For This Weekend: Peter Buffet (son of Warren) on Philanthropy

After a lengthy career as one of the world's best investors, Warren Buffet is, undoubtedly proud of his financial accomplishments.  However, I suspect he's even prouder of his son Peter Buffet, who explains the fundamental inability of big-time philanthropy to solve any of our basic problems in a wonderful Op-Ed in the New York Times.